Transfer pricing is essentially the pricing arrangements between related parties operating in different, or occasionally the same, tax jurisdictions. Kirsty Rockall explains how it can support the implementation of ESG, Pillar 1 and Pillar 2.

The aim of transfer pricing is to determine the appropriate prices at which goods, services, or intangible assets are transferred between these parties. By doing so, profits are allocated among multi-national companies (MNCs) global operations, considering factors such as market conditions, functions performed, and risks assumed.

This complex mechanism enables MNCs to manage their global tax liabilities, including those related to environmental, social and governance (ESG) factors, and potential tax reforms under the Organisation for Economic Cooperation and Development's (OECD) Pillar 1 and Pillar 2 initiatives.


Transfer pricing and ESG

ESG principles refer to a set of criteria that assess the impact of a MNCs operations. As groups strive to align their business practices with sustainable development goals, ESG is becoming an integral part of corporate strategy. Transfer pricing intersects with ESG in several ways. These include ESG-driven changes to:

  • business models and supply chains
  • increased environmental costs and savings
  • the development of new products and processes
  • new regulatory requirements.

ESG influences the performance of a business, in turn impacting the value created by a group. The underlying principle for transfer pricing is that profits (or losses) should be taxed where value is created. If value creation shifts due to ESG considerations, then this needs to be reflected in transfer pricing policies. The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines) don't directly address how ESG principles should be assessed (yet), but that doesn’t mean that you shouldn’t already be incorporating these principles into your transfer pricing analysis.


How tax can add value to your ESG agenda? Watch the video to hear from David Murray, Head of Tax Policy and Sustainability at Anglo American.


Using transfer pricing to incentivise environmentally-friendly policies

Consider a MNC involved in the production of electronic devices. The group operates manufacturing facilities in multiple countries, including an emerging nation with limited environmental regulations. The group wants to ensure its transfer pricing practices align with ESG principles. In this scenario, the group can implement transfer pricing policies that incentivise environmentally-friendly practices. For instance, the group could allocate a higher share of profits to entities that adopt clean technologies, reduce emissions, and implement sustainable waste management practices. By doing so, the company encourages its subsidiaries to prioritise environmental sustainability and minimises the negative impact on local ecosystems and communities.

Furthermore, the company can establish transfer pricing mechanisms to address social considerations, supporting local economic development, job creation, and social well-being. This can help uplift communities and improve the quality of life for local populations.

By integrating ESG principles into its transfer pricing policies, the MNC demonstrates its commitment to responsible business practices. It ensures that profits and taxes are distributed in a transparent and equitable manner, fostering good governance, and ethical behaviour within its organisation. To implement this successfully, the MNC will need to ensure that it has a detailed economic analysis and an accurate delineation of potentially new functional, risk and asset profiles to ensure that the transfer pricing policy can stand up to tax authority scrutiny.

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Transfer pricing and the ‘two-pillar solution’

What is known as the ‘two pillar solution’ is comprised of Pillar 1 and Pillar 2.

Pillar 1 aims to ensure a fairer distribution of profits and taxing rights among countries with respect to the largest MNCs. It introduces the concept of the market jurisdiction and magnifies its relevance to transfer pricing analysis. Market jurisdictions are jurisdictions to which goods or services are supplied or where consumers or users are located.

Pillar 2 addresses the ‘race to the bottom’ competition on corporate income tax through the introduction of a global minimum corporate tax at a rate of 15% that countries can use to protect their tax bases (the GloBE rules).

What is Pillar 1?

There are two parts to Pillar 1: Amount A and Amount B. Amount A provides a new taxing right to market jurisdictions by reallocating a portion of ‘in-scope’ profit based on a formulary approach and Amount B is intended to streamline the application of the arm’s length standard for baseline marketing and distribution activities. Both will require MNCs to determine the value of their cross-border transactions more accurately and allocate profits to the jurisdictions where they're generated.

There's no threshold proposed for MNCs to be within scope of Amount B. This is in contrast to both Amount A and the global minimum tax rules under Pillar 2, where specified thresholds would apply for determining whether an MNC is within scope.

Amount A will be implemented via a multilateral convention (MLC), which is scheduled to be finalised by mid-2023 for entry into force in 2024. Amount B in contrast will be implemented via OECD guidance, with the final deliverable also expected to be available by mid-2023.

Amount A is unlikely to impact many MNCs and there's limited interaction between the two Amounts, but Amount B may have far-reaching unintended consequences depending on how the scope is finalised. These could include:

  • decreasing in tax administration enquiries focusing on comparables, but potentially increasing focus on the characterisation of the business leading to long drawn out investigations
  • difficulty enforcing or ensuring the consistency of the implementation of the Amount B guidance, which may lead to further transfer pricing disputes
  • reducing the efficiency of previous tax efficient (and legal) structures
  • conflicting with Customs Duty Valuation Method 1 if a target margin is used to reward baseline activities
  • opening the door for prescribed rates for other transactions, including for example contract manufacturing
  • influencing how tax administrations may view the arm’s length principle in the future.

Consider a wholesale goods distributor that operates a ‘hub and spoke’ regional distribution model. Depending on the industry it operates in, a 2% operating margin for a baseline distributor may be compared as higher or lower against the operating margin previously earned by the low-risk distributors (LRDs). If it's higher, then is there a historical risk that the MNC hasn't recognised enough profit in the LRDs. Where will the future increase in profit come from? Does the regional principal earn enough profits to sustain the higher operating margins? If it's lower, should the excess profits be allocated to the regional principal or another entity?

Detailed transfer pricing analysis will be required to navigate these discussions and communicate any impact to stakeholders.  


Find out more about Pillar 1 Amount B and the perception of its scope. Watch the video to hear from Avni Dika, Head Group Transfer Pricing and Tax Lead Brazil at Syngenta.


What is Pillar 2?

Pillar 2 describes a very formulaic and mechanical approach to tax. Does this mean that transfer pricing is no longer relevant in a Pillar 2 context?

Pillar 2 is made up of three interlocking rules: the income inclusion rule (IIR), the undertaxed payment rule (UTPR), and the qualified domestic minimum top-up tax (QDMTT). The IIR imposes a top-up tax at the parent entity level that effectively allows countries to ‘top up’ the tax on earnings of foreign subsidiaries with effective rates below 15%. The UTPR will generally deny deductions with respect to members of a group with an effective rate below 15% that aren't otherwise subject to an IIR. However, countries will be allowed to impose a QDMTT that will take precedence over either an IIR or UTPR. It will effectively top up the tax on domestic entities to 15% to prevent another country’s IIR or UTPR from capturing the revenue.

Pillar 2 seeks to disincentivise MNCs from parking profits in very low tax jurisdictions via abusive transfer pricing planning. Its influence is therefore limited to extreme transfer pricing policies which tend to be in the minority. Pillar 2 doesn't erase the need for transfer pricing, indeed the starting point for any Pillar 2 assessment or calculation will be transfer pricing since under first principles, the GloBE rules require cross border intragroup transactions to be priced in accordance with the arm’s length principle.


How can you prepare for Pillar 2? Watch the video to hear from Dragos Dancau, Global Tax Manager at Ericsson.


Transfer pricing is a complex mechanism that requires careful analysis, documentation, and collaboration between businesses and tax authorities. By setting prices at arm's length, companies can enhance operational efficiency, demonstrate adherence to ESG and comply with international regulations. However, the challenges associated with determining appropriate pricing methodologies and the increased scrutiny from tax authorities need meticulous compliance and transparency.  

For more insight and guidance, get in touch with Kirsty Rockall.

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